What Chart 3 implies is that today’s reward relative to risk – yield per unit of duration is more or less half of what it has been for the past 15–20 years. In order to get the same yield today for a single unit of duration for AAA, BBB, and HY bonds, an investor has to take twice the price risk! Since duration and correlated maturities are simply measures of interest rate risk, that may simply be pointing out that yields are historically low, and yes – they still are. But in order to capture other elements of return such as credit, curve, volatility and currency, the average bond investor must generally attach those elements of “carry” to a bond with a duration. Swaps, CDS, and FRN’s provide a partial escape but for the cash investor, today’s yield per unit of duration is only half of the markets’ 15–20 year historical measure, and that is very, very low dear reader.
How to confront this? There are at least two ways at the extreme, I suppose. Either double your position – double your duration – and maintain the same yield as historically noted or maintain or even lower your duration as a concession to an overpriced market that may continue to suffer increasing yields and lower prices. Do you want to “double up to catch up” as Vegas blackjack dealers used to encourage me, or are you willing to suffer the lower yields, wait for “mean reversion” as do some of our competitors, and hope that the client cash outflows don’t cash you out before you have a chance to play another game? Future Sharpe ratios and investment management firms hang in the balance.
Well, as Bill Sharpe’s contemporary Harry Markowitz pointed out long ago, investing is a process of compromises involving diversification, and many times the compromise provides a return relative to risk that is more “efficient” than any other. If a portfolio were to seek a high Sharpe ratio using a Markowitz efficient portfolio, what might it look like today?
PIMCO recommends overweighting credit and to a lesser extent volatility and curve. Underweight duration. Although credit spreads are tight, they are not as compressed as interest rates, which are now in the process of normalization. While PIMCO agrees with Janet Yellen that such normalization will be a long time coming (the 12th of Never?), probabilities suggest that as the Fed completes its Taper, the 5–30 year bonds that it has been buying will have to be sold at higher yields to entice the private sector back in. The 1–5 year portion of the curve, beaten up recently due to Fed “blue dot” forecasts and Yellen’s “six months after” comments, should hold current levels if inflation stays low, but 5–30 year maturities are at risk. Overall, because 2014 should be a relatively positive growth environment, carry trades in credit, curve and volatility should produce attractive Sharpe/information ratios. Return expectations however, for all unlevered assets and Markowitz generated portfolios will be in the low- to mid-single digits.
And what would Bob have meowed? Well, like I wrote, she was always more certain about pet food stocks, but then maybe kitty heaven has given her some additional insight. I shall have to ask her in my dreams. Sometimes dreams come true you know.
Bob’s Speed Read
1) High Sharpe ratios have been due to a long-term bull market. They will be lower in future years, as will asset returns.
2) Yields per unit of duration are historically low – half of their 15–20 year averages as shown by CreditSights.
3) Favor credit spreads and to a lesser extent, curve and volatility carry trades.
4) Treasure your pets and all living things. Eventually we all stop living.